EUROPEAN UNION S COMPETITIVENESS IN TERMS OF COUNTRY RISK AND FISCAL DISCIPLINE

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1 EUROPEAN UNION S COMPETITIVENESS IN TERMS OF COUNTRY RISK AND FISCAL DISCIPLINE MIHAIU Diana Lucian Blaga University of Sibiu, Romania OPREANA Alin Lucian Blaga University of Sibiu, Romania Abstract: Underneath the umbrella of national competitiveness there are microeconomic and macroeconomic factors, but the recovery and the revival of a state competitiveness must be based on a strategy developed and coordinated centrally and implemented in strategic areas of the economy. In this respect, this paper aims to analyze the situation of European Union s competitiveness in terms of country risk and fiscal and budgetary discipline of the Member States, based on empirical data. Therefore, this study s analysis includes the following two steps: first, a segmentation of the European Union by determining distinct groups of countries according to national competitiveness (GCI), public debt (PD) and budget equilibrium (BD); and second, a factor analysis performed on the resulted clusters of countries based on GCI, PD, BD and CDS (credit default swap). Keywords: sovereign debt crisis, country risk, fiscal and budgetary discipline, competitiveness 1. Introduction After almost four years since the economic crisis has debuted, we are witnessing a slow recovery of national economies, and in some cases there are setbacks. Most European economies have resorted to massive public borrowing in order to finance their budget deficits, thus generating a new crisis, namely the sovereign debt crisis. This type of crisis requires special attention and a number of correlated measures of economic and fiscal policies, since its effects tend to be long term and to affect the business environment which is the engine of economic recovery. Country risk is a variable affected by this condition and it negatively influences not only the cost of new loans but also the attractiveness of the economy, and as a result the interest of potential foreign investors to invest in that particular country. However, the recovery Studies in Business and Economics

2 capacity of the national economy in such a situation can be found in the actual cause that generated it in the first place, namely the budget and fiscal discipline. Country risk is a topic extensively pursued for decades, and during this timeframe analyses and quantification methodologies have diversified giving rise to a series of country ratings. Although they are closely considered, these country ratings are also criticized and the rating agencies are being accused of lack of objectivity and market manipulation. Country risk assessment is a multidimensional problem that is of major interest to policymakers, managers of international lending institutions, multinational firms, and investors (K. Kosmidou, M. Doumpos, C. Zopounidis, 2008). Country risk analysis involves the research and risk calculation of investing in a country. Many factors are considered when completing a country risk analysis, such as financial factors and stability factors, as all of these or even just one can adversely impact the value of the investment. Analyzing a country's risk factor is an arduous process that involves a lot of socio-economic expertise (Buchanan, 2011). Regardless of the number of indicators taken into consideration when quantifying country risk, it has its source in three components of an economy, namely the political, economic and financial component (Lazarescu Sorin). Figure 1: Country risk components Determination of the sovereign risks is made by specialized rating agencies, such as: Standard & Poor's, Fitch, Moody's, COFACE and by some financial publications, such as: The Economist, Euromoney, etc. Variables considered to measure the country risk are specific to each methodology (see Table 1). Studies in Business and Economics

3 Table 1: Variables considered in measuring country risk by various methodologies METHODOLOGY STANDARD and POOR s COFACE ECONOMIST INTELLIGENCE UNIT EUROMONEY Studies in Business and Economics VARIABLES USED 1. Political risk 2. Public debt level 3. Price stability 4. Income economic structure 5. Balance of external payments flexibility 6. Prospects for economic growth 7. Fiscal flexibility 8. External debt and the degree of liquidity 1. Growth vulnerability 2. Sovereign financial vulnerability 3. External over indebtedness 4. Foreign exchange liquidity-crisis risk 5. Banking sector s fragilities 6. Political vulnerabilities 1. Securities 2. Political stability 3. Government effectiveness 4. Legal and regulatory 5. Macroeconomic 6. Foreign trade and payments 7. Financial 8. Tax policy 9. Labor market 10. Infrastructure 1. Political risk 2. Economic performance 3. Structural assessment 4. Debt indicators 5. Credit ratings 6. Access to bank finance 7. Access to capital markets Source: information adapted from: pays rkctry&page_title=latest%20alerts&rf=0 COFACE The Handbook of country risk. A Guide to International Business and Trade, Coface and GMB Publishing Limited, 2008.

4 In terms of a country s fiscal and budgetary policies, it is obvious that these have an important role in overcoming the economic crisis, leading to economic recovery and ensuring its stability. However, an issue that arises in the present controversy is the nature of budgetary and fiscal policy during economic crisis: to adopt a pro-cyclical fiscal and budgetary policy, a neutral or a countercyclical one. We have witnessed a series of pro-cyclical measures in most EU member countries, and a series of countercyclical measures in the USA, but their results remain yet undefined. Whatever the nature of fiscal and budgetary policy in a country, it must first ensure its sustainability that is a fiscal and budgetary discipline. In this respect, 25 EU Member States, including Romania, have adopted the Treaty of budgetary discipline, which will take effect no later than January 1, 2013, which implies: - The budget deficit to be up to 3 GDP and public debt up to 60 GDP, also these two provisions should be introduced in the Constitution; - A structural deficit of 0.5%; - Member states must inform the European Commission on their issuance of bonds. However, budget deficit and public debt, fiscal and budgetary discipline, CDS, along with other macroeconomic indicators leave a mark on national competitiveness. It is true that underneath the umbrella of national competitiveness there are microeconomic and macroeconomic factors, but the recovery and the revival of a state competitiveness must be based on a strategy developed and coordinated centrally and implemented in strategic areas of the economy. 2. Methodology and Empirical Study In this section the situation of European Union competitiveness is analyzed in terms of country risk and fiscal and budgetary discipline of the Member States, based on empirical data. In the analysis we consider the following four components as exogenous variables that characterize the economic situation in the European Union: competitiveness (expressed in the Global Competitiveness Index), public debt in GDP, budget balance (expressed by the budget deficit) and CDS (credit default swap). Thus, the indebtedness and budget equilibrium (that is BD budget deficit) are expressed as the percentage of public debt in GDP, using Eurostat as the data source. Furthermore, the competitiveness level of countries covered in this study is given by the Competitiveness Index calculated annually by the World Economic Forum. Also, the CDS (Credit Default Swap) is expressed in basis point (bps) and the data is collected from Bloomberg. The analysis covered by this study includes the following two steps: 1. A segmentation of the European Union by determining distinct groups of countries according to GCI, PD, and BD; 2. A factor analysis performed on the resulted clusters of countries based on CDS, GCI, PD, and BD. Studies in Business and Economics

5 2.1. European Union Segmentation The first stage of the analysis was intended to obtain relevant clusters of countries characterized by similar results of the three variables considered (GCI, PD and BD). To achieve this objective, we used the Two-Step Cluster method which led to the following situation regarding the clusters relevance: Figure 2: Segmentation Model Summary Using the Two-Step Cluster method (Figure 2) on three variables, 3 clusters were developed which have a high relevance in terms of their quality. In the figure below (Figure 3), each segment is characterized through their relative and absolute proportions, the countries which formed each cluster, and the score for each variable used in the Two-Step Cluster method. Figure 3: Cluster Dimensions Studies in Business and Economics

6 Figure 4: Clusters of EU countries Thus, we identified three segments, with the following features: Table 2: Clusters of EU Countries Cluster Characterization Features Countries A B High competitiveness Moderate competitiveness 5.26 High national competitiveness Medium public debt 4.18 High level of fiscal and budgetary discipline 4.37 Medium national competitiveness Low public debt 5.70 Medium level of fiscal and budgetary discipline Austria Belgium Denmark Finland France Germany Netherlan ds Sweden United Kingdom Bulgaria Czech Republic Cyprus Studies in Business and Economics

7 C Low competitiviness 4.37 Medium national competitiveness Medium public debt Low level of fiscal and budgetary discipline Estonia Hungary Latvia Lithuania Malta Poland Romania Slovakia Slovenia Spain Greece Ireland Italy Portugal Table 3 represents a descriptive analysis of the three clusters, as an intermediate phase transitioning to the second stage of the overall analysis. Two Step Cluster Number A B C Table 3: Descriptive Statistics N Minimum Maximum Mean Std. Deviation pd gci cds bd Valid N 9 pd gci cds bd Valid N 11 pd gci cds bd Valid N Studies in Business and Economics

8 2.2. Factor Analysis Further, the study aims to achieve a factor analysis using the Principal Component Analysis as the extraction method, and the Varimax method as the rotation method, while performing a Kaizer normalization for each of the three clusters previously resulted. Factor Analysis of Cluster A The results obtained from performing factor analysis on cluster A are presented in the following tables (4 and 5): Table 4: Variance Explained for Cluster A Component Initial Eigenvalues Varianc e Cumulati v Extraction Sums of Squared Loadings Varian ce Rotation Sums of Squared Loadings Varianc e Table 5: Rotated Component Matrix for Cluster A Component ρ ϕ pd gci cds bd It can be noticed that cluster A is influenced by two main factors: country risk and budgetary and fiscal discipline. In the current economic situation, a country risk rate of 57.47% influences the competitiveness of segment, while the fiscal discipline influences at a rate of 34.13%. F A = x ρ A (pd,gci,cds) x ϕ A (bd) + ε A where F Cluster Competitiveness, ρ Country Risk, ϕ Budgetary and Fiscal Discipline. Studies in Business and Economics

9 Factor Analysis of Cluster B Component Table 6: Variance Explained for Cluster B Initial Eigenvalues Varian ce Extraction Sums of Squared Loadings Varian ce Rotation Sums of Squared Loadings Varianc e Table 7: Rotated Component Matrix for Cluster B Component ρ ϕ pd gci cds bd Tables 5 and 6 show that cluster B is influenced by two main factors: country risk and fiscal and budgetary discipline. In the current economic situation, a country risk rate of 43.98% influences the competitiveness of segment, while the fiscal discipline influences at of 32.40%. F B = x ρ B (gci,cds) x ϕ B (pd,bd) + ε B where F Cluster Competitiveness, ρ Country Risk, ϕ Fiscal and Budgetary Discipline Studies in Business and Economics

10 Factor Analysis of Cluster C Compone nt Table 8: Variance Explained for Cluster C Initial Eigenvalues Variance Extraction Sums of Squared Loadings Varianc e Cumulati v Rotation Sums of Squared Loadings Varianc e E E Table 9: Rotated Component Matrix for Cluster C Component ρ ϕ pd gci cds bd Regarding cluster C, tables 7 and 8 present as two main influencers country risk and fiscal and budgetary discipline. In the current economic situation, a country risk rate of 59.43%influences the competitiveness of the segment, while the fiscal discipline influences at of 37.96%. F C = x ρ C (pd,gci,cds) x ϕ C (bd) + ε C where F Cluster Competitiveness, ρ Country Risk, ϕ Fiscal Discipline. 3. Results and Conclusions In the present study, the following methods were used: Two-Step Cluster (for the EU segmentation), and Factor Analysis for each of the segments resulted, with Principal Component Analysis as the extraction method and Varimax as the rotation method. Thus, in the process of segmentation using Two-Step Cluster, the following situation has been identified at EU level: Studies in Business and Economics

11 Table 10: Clusters of EU countries Country gci2010 pd2010 bd2010 Characterization Sweden Finland Netherlands Denmark Germany United Kingdom France Austria Belgium Luxembourg Estonia Czech Republic Poland Cyprus Spain Slovenia Lithuania Malta Hungary Slovakia Romania Latvia Bulgaria Ireland Portugal Italy Greece (Source: Eurostat, World Economic Forum) A - High competiveness B - Moderate competitiveness C - Low competitiviness Using factor analysis for each of three clusters resulted (A, B, and C), we obtained the following situation: F A = x ρ A (pd,gci,cds) x ϕ A (bd) + ε A Studies in Business and Economics

12 F B = x ρ B (gci,cds) x ϕ B (pd,bd) + ε B F C = x ρ C (pd,gci,cds) x ϕ C (bd) + ε C where F Cluster Competitiveness, ρ Country Risk, ϕ Fiscal Discipline. The current level of competitiveness of the European community is presents distinct characteristics for clusters A and C compared with segment B. Thus, the moderate level of competitiveness that characterizes segment B is a direct relationship with country risk and an inverse relationship with fiscal discipline (influenced by public debt and budget deficit). In contrast, the competitiveness of segments A and C presents itself in an inverse relationship with country risk and in a direct relationship with fiscal discipline. Cluster s A high competitiveness is determined by a lower level of country risk and a greater level of fiscal discipline. Also, the reduced competitiveness of this segment is due to a higher country risk (mainly influenced by a high share of debt public in GDP) and a lower degree of fiscal discipline, as a result of a poor policy of balancing the budget. 4. References Buchanan Paul - Factors for Consideration in Country Risk Analysis, 2011, COFACE The Handbook of country risk. A Guide to International Business and Trade, Coface and GMB Publishing Limited, K. Kosmidou, M. Doumpos, C. Zopounidis - Country Risk Evaluation, Springer Science+Business Media, LLC 2008, pag Lazarescu Sorin Rating financiar, Biblioteca ASE, Capitolul Ratingul si riscul de tara, pag.2, methodrisquepays &refm=rkCtry&page_title=Latest%20alerts&rf= Studies in Business and Economics